SYNTHESIS DEEP DIVE
Our approach incorporates elements of various trading strategies and concepts. Below is an overview of several concepts utilized in our SYNTHESIS Investment Program.
Stage Analysis is a concept used to observe the big-picture trend state of a price structure. It is useful when analyzing the current trend on any price series (stocks, bonds, ETF's, commodities, etc.). The premise is that over a complete cycle, all prices go through 4 Stages as illustrated in the accompanying chart.
*Accumulation
*Markup
*Distribution
*Markdown
Or, to put it another way:
*Bottom
*Uptrend
*Top
*Downtrend
It is important to understand the current price stage of a given financial instrument when making trading decisions. Ideally, one is patient/stalking new ideas in Stage 1, aggressively positioned in Stage 2, reducing risk in Stage 3, and out of the market/position (or short) if price is in Stage 4. In Stage 2, volatility is "tolerated". In Stage 4, volatility is "mitigated". Here is a detailed depiction of the four stages courtesy of Alphatrends.net.
The Buy and Hold Strategy requires investors to be fully invested during Stage 4. Many are unable to withstand the pain of a sustained Stage 4 decline and ultimately capitulate just as prices enter the bottoming process and Stage 1. Our approach seeks to avoid exposure to prices in a Stage 4 decline unless for a short-term, counter-trend, trade or a short trade where we seek to profit from falling prices.
Sector Rotation refers to the evolution in leadership among various sectors and asset classes over time. Today's leaders eventually become tomorrow's laggards and vice versa. Conventional wisdom says to diversify among many asset classes as it is impossible to predict which asset classes and sectors will outperform in the days, weeks, and months to come. Those espousing this approach often use a Callan Chart to illustrate the performance of various asset classes year-to-year.
We view the Callan Chart through a different lens. Rather than making the case for diversification, we view the Callan Chart as making the case for using Sector Rotation in concert with Stage Analysis when making broad allocation decisions. If you look closely at the bottom row of the chart (just right of center) you see a 4-year period where the asset class shaded in light green was the worst performing asset class. Rather than have this asset class in our allocation, our approach would avoid this asset class until signs of entering a Stage 2 uptrend were present. Why allocate available funds to an asset class that is clearly a laggard when there are other options available?
The chart also illustrates how an asset class can exhibit leadership over a multi-year period. The dark green boxes at the top of the chart (just right of center) show sustained leadership over a 5-year period. Leadership like this is where we want to allocate client funds.
Momentum is long recognized as a successful investing strategy. The subject of many academic papers, momentum is a valid approach to investing and trading. Sometimes referred to as "Relative Strength", momentum refers to the tendency of recent winning stocks to remain winners in the near future and for lagging stocks to remain laggards over the near term. Studies show momentum works best over 3-month to 12-month time periods. We utilize the concepts of momentum/relative strength in two ways.
First, we use Relative Strength to identify leaders and laggards among asset classes, sectors, commodities, currencies, regions of the world, etc. over a given time period and to monitor changes in leadership as it evolves over time. Here is a screenshot illustrating the rankings of our ETF universe.
RS Ranking created using HGSI software.
The software calculates the performance of each ETF versus the S&P 500 over a designated look back period. As strength improves or wanes, the color changes to reflect the change in strength. Green shows areas of out performance over the look back period, yellow is neutral, and red reflects under performance. We monitor the Relative Strength rankings at the end of each week.
The second way we use momentum is to manage our equities positions. In our SE Strategy, we seek to identify leading stocks in leading sectors and add them to the portfolio as early in their momentum move higher as possible. We also seek to remove them from our portfolio as momentum wanes. To implement this approach we search a database of over 8,000 symbols to filter down to the 350 or so stocks that meet our criteria. From there we run additional screens with strict criteria to further reduce the list of potential stocks to those presenting a high likelihood of moving higher sooner rather than later. This culminates in our PHARCAP 50 which is a list of growth stocks that is our focus during the week. We follow these stocks on a daily basis looking to enter new positions at pre-determined price levels. Here is a sample screenshot of the PHARCAP 50. The list is sorted from strongest to weakest based on the Raw Combo Rank column.
PHARCAP 50 created using HGSI software.
This is just an overview of how we incorporate Momentum/Relative Strength into our process. There are specific techniques we use to implement the strategy. These specifics are beyond the scope of this overview.
Trend Following is a strategy that seeks to identify trends as early in the trend as possible and hold positions until the trend ends. Similar to relative strength, the difference between trend following and relative strength is how each is calculated.
Trend following compares the price of a symbol to the price of the same symbol at some previous point in time. For example, if price makes a new 200-day high, price is higher than at any other time over the past 200 days This is an absolutely true statement and not subject to comparison with the price of another symbol over that same time period. Since the only comparison is to absolute price levels over a given period of time, this is referred to as "absolute" or "time-series momentum".
This differs from the calculations for Relative Strength (RS) in that the RS calculation compares the performance of one symbol against a different symbol (the S&P 500 for example). This type of momentum is referred to as "relative" or "cross-sectional momentum".
We incorporate elements of both time-series momentum and cross-sectional momentum in the management of our SGO Strategy.
Position Sizing is an integral component of our active risk management process. Position sizing answers the question of "how much" when adding a new position into the model. Our approach manages risk at the individual position level and the overall portfolio level. This process is called position sizing. For example:
Assume a $100,000 portfolio
Risk 1% of total portfolio on each position
Portfolio risk budget per position = $1,000 ($100,000 x 1%)
Buy XYZ stock for $100. Will exit position if price falls to $90
Risk per share = $10 ($100 - $90)
Portfolio risk budget per position = $1,000
XYZ risk per share = $10
$1,000 /$10 = 100 shares position size for XYZ
Buy 100 shares of XYZ @ $100 = $10,000 total position size
If price of XYZ falls to $90 and the position is sold we incur a $10 per share loss.
$10 per share loss x 100 shares = $1,000 loss to portfolio which is our original risk budget for this position.
We complete this process for each position in the model.
At the portfolio/model level, if we have ten positions in the model and each position risks 1% of the model value, then we have 10% risk in the model if all ten positions are exited at their planned stop loss price.
The variables may (and do) vary, however this thought process is fundamental to our approach for managing risk at the position and portfolio level.
An ETF, or exchange-traded fund, is a marketable security that tracks a stock index, a commodity, bonds, or a basket of assets. Although similar in many ways, ETF's differ from mutual funds because shares trade like common stock on an exchange.
This is a simplified definition of ETF and is sufficient for our purposes. From our perspective, ETF's allow us to quickly and cheaply gain access to investment classes around the world. ETF's trade during the day and are more tax-efficient than traditional mutual funds. There is an ETF available for virtually any asset class we could possibly include in a model portfolio. Each ETF has an objective and all we need to do is determine if we want exposure to that objective. For example, if we want broad exposure to gold mining companies we can purchase the Gold Miners ETF (symbol GDX). The ETF manager manages the fund according to the fund's stated objective leaving us to determine how much to buy and when to sell. We use ETF's in our SGO Strategy.
We also use specialty ETF's in our ST Strategy. This is our shorter-term, tactical strategy. In this strategy we have the option to utilize leveraged ETF's and inverse ETF's to exploit opportunities and/or manage risk. For example, if our analysis indicates a market decline we can purchase an inverse S&P 500 ETF which will appreciate in value as the S&P 500 declines in value. This allows us to speculate on market direction or use potential gains in the inverse ETF to offset (hedge) losses in positions in other models we do not plan to sell.
ETF's are terrific money management vehicles and we utilize them extensively in our SYNTHESIS Investment Program.
